Commercial Mortgage Types and Decisions

Transcription

1 Commercial Loans vs Home Loans Fin 5413 Commercial Mortgage Types and Decisions Commercial mortgages and notes are not as standardized as home loans Although this is changing with growth in commercial mortgage-backed securities market Documents are longer and more complex. Often no personal liability: Legal borrower often is a single asset corporation. Actual persons are shielded from liability. Credit enhancement sometimes is required. McGraw-Hill/Irwin Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved Commercial Mortgage Loans Usually a partially amortized balloon mortgage. to 30 year amortization of principle. 5 to 10 year maturity Balance of loan at maturity must be refinanced or paid off with a balloon payment Bullet loans are non amortizing for with a fixed term at which point the principal is repaid Attractions of Balloon Mortgage to Lender Reduces interest rate risk. Reduces default risk. Default risk is much greater for commercial mortgage loans than for home loans. As with residential lending, default risk varies over time 7% delinquent in late % delinquent in % in 3 rd quarter of 2005 Actual yield to lender will generally be lower than scheduled yield due to defaults Commercial Mortgage Spread over Treasuries Exhibit Exhibit % Survey 11% Survey Rate Rate US US Treasury Treasury Yield Yield 10% 10% 9% 9% 8% 8% 7% 7% 6% 6% 5% 5% 4% 4% 3% 3% Mortgage rates highly correlated with Treasury Securities Restrictions on Prepayment Lock-out: Prohibition against prepayment for up to 5 years. Prepayment penalties: Percentage of loan: Say, 2-4% of loan balance. Yield maintenance penalty: Borrower must pay lender PV of losses due to prepayment. Defeasance penalty: Borrower must replace mortgage loan with a set of U.S. Treasury securities producing equivalent cash flows Recently has become most common form of prepayment penalty This replaces a risky promised set of CF s with a risk free set of CF s so its good for a lender

2 Financing Floating (i.e., adjustable) rate mortgage Index rate most commonly is LIBOR Installment sale financing Buyer makes installment payments. Seller only pays capital gain taxes over time in proportion to amount of the price received. Joint Venture Lender: Provides a mortgage loan Provides additional equity investment. Receives mortgage interest plus equity cash flows. Borrower: Provides the project. Provides expertise and management effort. Provides some of the equty Joint Venture - continued Usually between a developer of a large project and a: Pension fund. Life Insurance company. REIT Institution provides construction financing and/or long-term mortgage, in addition to some of required equity capital Institution s share of operating & sale cash flows are negotiated Land Sale-leaseback: Investor owns land and mortgage on building. User owns building subject to mortgage and p pays a land lease (both deductible for taxes) Sale-leaseback User sells property to a long-term investor. Pension fund. Trust. Life insurance company. User leases property back from the investor and occupies it under long-term net lease Sale-Leaseback - continued User benefits: Lease payment is deductible for income taxes. Equity capital is freed up to invest in core business of company. Investor benefits: Can be safe investment (depending on credit worthiness of tenant). Inflation hedged (especially if lease payments increase with inflation). Mezzanine Debt (growing in popularity): Supplements underlying first mortgage debt. Sometimes is a second mortgage loan (i.e., secured by the property) More often is a non-mortgage loan secured by a pledge of ownership shares If borrower defaults lender takes over the borrower s ownership position rather than having a lien on the real estate (which the first mortgage holder has)

4 The Leveraging Question (How much debt?) Reasons for use of debt by investors: Magnify equity returns. Diversify the use of one s equity. Financial risk: Risk of default on mortgage loan. Risk of negative cash flow. Increases with greater leverage. Leverage increases variability of equity returns. When Will Leverage Increase NPV and Going-in IRR? Increased leverage will increase the estimated NPV when. opportunity cost of equity capital (discount rate) exceeds the effective borrowing cost Increased leverage will increase the goingin IRR when. unlevered going-in IRR exceeds the effective borrowing cost Leverage Bottom Line In a typical cash flow forecast, increased leverage will increase the estimated NPV and going-in IRR Why must this be true? However, this increased NPV/IRR comes at a price..increased riskiness of the equity investment The more leverage used, the more the equity resembles an option Refinancing and Default with Commercial Mortgage Loans Refinancing involves a NPV decision. Even more focused on NPV than home mortgage refinancing. Bigger finance issues. Fewer non-financial considerations. NPV = PV OLD PV NEW RefiCost Prepay Penalty PVNew is presumably smaller due to lower pmts. The prepay penalty is often so large that it negates any advantage to refinancing Refinancing and Default with Commercial Mortgage Loans Default is the signature risk of commercial mortgages. Borrower seldom can cover the loan payment for a crippled commercial property. Borrower often is in a non-recourse position (good for the borrower, bad for the lender). Financing Income-Producing Property: Borrower Perspective Influence on Management of Property Maximum Leverage Straight Debt Strong 75-80% of Value Joint Venture Land Sale- Leaseback Complete Sale- Leaseback Property Asset Price Risk High Low Moderate None Depreciation Deductions Full Share Full None Priority of Claims to Cash Flow Second to Lender s Partners with Lender Claim Junior to Lender s and Landowner s No Ownership Interest 100% of Value

7 17-37 Construction and Development Financing Land acquisition financing Finance the purchase of raw land Land development loan Finance the installation of improvements to the land (sewers, utilities, etc.) Construction loan Finance the vertical construction Mini-perm loan A permanent loan with a short term Summary For commercial lending, the building produces the income that is used to pay off the lien The ability of the building to produce cash flows is what the lender evaluates Priced off the 10 year Treasury Securities (2-3% average spread) Loans typically are balloon loans with a 5-7 year term and -30 year amortization Prepayment penalties common Underwriting focuses on DCR and LTV CMBS is a growing source for placement of commercial mortgages 7

Commercial Mortgage Types and Decisions Commercial mortgages & notes for existing properties not as standardized as home loans Documents are longer & more complex Often no personal liability: Legal borrower

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